Why portfolio diversification is a time-tested virtue

At no time in recorded financial history has the benefit of portfolio diversification been so evident as today. The expression ���don���t put all your eggs in one basket��� is most apt for investing, and diversification is one of the most important principles to keep in mind when constructing an investment portfolio. We are in a truly global investment environment and the definition of portfolio diversification too is constantly changing. It used to be just equities, bonds and cash but over the last few years, partly due to increased risks as well as opportunities, the list now includes commodities, currency, art, foreign market investments and a host of other options which were once termed exotic or ���alternative���.

An ideal diversified portfolio should contain different asset classes, investment styles, and mixed assets from different geographic regions. Studies have conclusively shown that a diversified portfolio of non-correlated investments reduces risk and improves overall return.

Your typical equity fund manager may have told you that you should diversify ��� but in different equity sectors such as infrastructure, telecom, pharma and so on. But as recent experience shows, investing in market sectors that tread in the same direction will not help much. I���m not saying that other assets��� prices haven���t fallen, but they don���t and they won���t move in tandem with equity prices.

Portfolio diversification can also be in terms of timing. Research has shown that individual asset classes perform well over a few years at best. Therefore, you could be investing in equities at one time and commodities the next. For example, many HNIs who exited equities in January this year, jumped on the commodity bandwagon for the next several months, making handsome profits. This particularly suited those who have a long-only fixation with markets. Since it���s not possible to predict which asset class will excel in any year, therefore diversification allows you to participate in the best-moving asset class of the time.

So how does one diversify? The trick is to add asset classes with zero or negative correlation between them. Since most portfolios contain equity, bonds and cash, we need to add assets which have no correlation with these.

WHY COMMODITIES

Commodities have low to negative correlation to traditional asset classes like stocks and bonds which means that investment in commodities is a real portfolio diversifier leading to lower risk. International experience shows that while stocks and mutual funds are closely related to each other (since mutual funds typically invest in stocks anyway) and tend to have positive correlation with one another, commodities are a bet on inflation and have a low to negative correlation to other asset classes and are therefore a well-advised addition to almost every long-term investment portfolio.

As far as the financial nature of commodity futures markets are concerned, they are as much or as less risky as equity markets. International information flow, liquidity, long trading hours and an impossible-to-rig global market make commodities irresistible to fund managers of all hues. Long term commodity investors like the idea that prices can���t really decline beyond a point ��� much unlike equity, where the floor is virtually zero.

We feel that commodity investing is easier and more logical than other investment forms because commodity prices move due to actual or perceived demand/ supply factors and are therefore simpler to price rather than equities which have earnings, management quality and company cash flows as issues for pricing in which add to the ambiguity. For example, in the first quarter of 2008, steel prices rose but prices of steel companies fell due to sector re-rating in the face of a global slowdown. Knowing that steel prices were firming up, you would have made money if you took a long position in steel but lost pots of money if you took a long position in the very steel companies which were benefiting from the price rise!

INVESTMENT STYLES IN COMMODITIES

There are several investment options in commodity business. Typical long-only investors find comfort that buying and holding is just like equities ��� you can buy commodities and hold them in demat form till the time you sell. Conservative investors may choose safe products like spot ��� futures arbitrage in which your broker buys a commodity for you from the ���Mandi��� or spot market and simultaneously executes the second leg by selling the same commodity in the same quantity in the futures exchange locking in the profit. The returns work out best for agricultural commodities. Similarly, spread-trading is a popular strategy in commodities as is inter-exchange arbitrage. There are other exciting and novel ideas being floated such as buying gold, hedging it immediately and simultaneously using it as margin in commodity/equity trading, an idea whose time has come.

Commodity prices are falling today. So if there is no guarantee that prices will go up quickly, then where is the guarantee of returns? Aggressive investors know that commodities markets globally are futures based and you may be just as likely to short a commodity as long. For traditional investors, this comes as a paradigm change but the best fund managers and largest funds access commodity markets in this manner. This is also the reason why volumes in commodity futures exchanges remain firm even though prices have crashed. In other words, investors do not ignore chances for profit but depending on the mode of investment can be classified as either aggressive or conservative. Therefore aggressive investors may simply take futures positions and operate on both sides of the market ��� up and down.